ACQUISITION AND DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT

JOIN KHALID AZIZ • FRESH CLASSES • ICap module b & d • FINANCIAL ACCOUNTING, ECONOMICS & COST ACCOUNTING • INDIVIDUAL & GROUPS

JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. • CONTACT: • 0322-3385752 • 0312-2302870 • R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

Learning Objectives • Describe property, plant, and equipment. • Identify the costs to include in initial valuation of property, plant, and equipment. • Describe the accounting problems associated with self-constructed assets. • Describe the accounting problems associated with interest capitalization. • Understand accounting issues related to acquiring and valuing plant assets. • Describe the accounting treatment for costs subsequent to acquisition. • Describe the accounting treatment for the disposal of property, plant, and equipment.

Acquisition and Disposition of Property, Plant, and Equipment Acquisition Valuation Cost Subsequent to Acquisition Dispositions • Acquisition costs: Land, buildings, equipment • Self-constructed assets • Interest costs • Observations • Cash discounts • Deferred contracts • Lump-sum purchases • Stock issuance • Nonmonetary exchanges • Contributions • Other valuation methods • Additions • Improvements and replacements • Rearrangement and reinstallation • Repairs • Summary • Sale • Involuntary conversion • Miscellaneous problems

Property, Plant, and Equipment Property, plant, and equipment includes land, buildings, and equipment (machinery, furniture, tools). Major characteristics include: • “Used in operations” and not for resale. • Long-term in nature and usually depreciated. • Possess physical substance. LO 1 Describe property, plant, and equipment.

Acquisition of PP&E Valued at Historical Cost, reasons include: • Historical cost is reliable. • Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold. APB Opinion No. 6states, “property, plant, and equipment should not be written up to reflect appraisal, market, or current values which are above cost.” LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Acquisition of PP&E Cost of Land Includes all costs to acquire land and ready it for use. Costs typically include: • the purchase price; • closing costs, such as title to the land, attorney’s fees, and recording fees; • costs of grading, filling, draining, and clearing; • assumption of any liens, mortgages, or encumbrances on the property; and • Additional land improvements that have an indefinite life. LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Acquisition of PP&E Cost of Buildings Includes all costs related directly to acquisition or construction. Costs typically include: • materials, labor, and overhead costs incurred during construction and • professional fees and building permits. LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Acquisition of PP&E Cost of Equipment Include all costs incurred in acquiring the equipment and preparing it for use. Costs typically include: • purchase price, • freight and handling charges • insurance on the equipment while in transit, • cost of special foundations if required, • assembling and installation costs, and • costs of conducting trial runs. LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Acquisition of PP&E E10-1 (variation):The following expenditures and receipts are related to land, land improvements, and buildings acquired for use in a business enterprise. Determine how the following should be classified: Classification Notes Payable • Money borrowed to pay building contractor • Payment for construction from note proceeds • Cost of land fill and clearing • Delinquent real estate taxes on property assumed • Premium on 6-month insurance policy during construction • Refund of 1-month insurance premium because construction completed early Building Land Land Building (Building) LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Acquisition of PP&E E10-1 (variation):The following expenditures and receipts are related to land, land improvements, and buildings acquired for use in a business enterprise. Determine how the following should be classified: Costs of: Building • (g) Architect’s fee on building • (h) Cost of real estate purchased as a plant site (land $200,000 and building $50,000) • (i) Commission fee paid to real estate agency • (j) Installation of fences around property • (k) Cost of razing and removing building • Proceeds from salvage of demolished building • Cost of parking lots and driveways • Cost of trees and shrubbery (permanent) Land Land Land Improvements Land (Land) Land Improvements Land LO 2 Identify the costs to include in initial valuation of property, plant, and equipment.

Acquisition of PP&E Self-Constructed Assets • Costs typically include: • Materials and direct labor • Overhead can be handled in two ways: • Assign no fixed overhead • Assign a portion of all overhead to the construction process. • Companies use the second method extensively. LO 3 Describe the accounting problems associated with self-constructed assets.

Acquisition of PP&E Interest Costs During Construction Three approaches have been suggested to account for the interest incurred in financing the construction. Illustration 10-1 Increase to Cost of Asset $ 0 $ ? Capitalize no interest during construction Capitalize all costs of funds Capitalize actual costs incurred during construction (with modification) GAAP LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Interest Costs During Construction • GAAP requires — capitalizing actual interest (with modification). • Consistent with historical cost — all costs incurred to bring the asset to the condition for its intended use. • Capitalization considers three items: • Qualifying assets. • Capitalization period. • Amount to capitalize. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Qualifying Assets • Require a period of time to get them ready for their intended use. • Two types of assets: • Assets under construction for a company’s own use. • Assets intended for sale or lease that are constructed or produced as discrete projects. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Capitalization Period Begins when: • Expenditures for the asset have been made. • Activities for readying the asset are in progress . • Interest costs are being incurred. Ends when: The asset is substantially complete and ready for use. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Amount to Capitalize Capitalize the lesser of: • Actual interest costs • Avoidable interest - the amount of interest that could have been avoided if expenditures for the asset had not been made. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Interest Capitalization Illustration:KC Corporation borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2011, for specific purposes of constructing special-purpose equipment to be used in its operations. Construction on the equipment began on Jan. 1, 2011, and the following expenditures were made prior to the project’s completion on Dec. 31, 2011: Other general debt existing on Jan. 1, 2011: $500,000, 14%, 10-year bonds payable $300,000, 10%, 5-year note payable LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E • Step 1 - Determine which assets qualify for capitalization of interest. • Special purpose equipment qualifies because it requires a period of time to get ready and it will be used in the company’s operations. • Step 2 - Determine the capitalization period. • The capitalization period is from Jan. 1, 2011 through Dec. 31, 2011, because expenditures are being made and interest costs are being incurred during this period while construction is taking place. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Step 3 - Compute weighted-average accumulated expenditures. A company weights the construction expenditures by the amount of time (fraction of a year or accounting period) that it can incur interest cost on the expenditure. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Step 4 - Compute the Actual and Avoidable Interest. Selecting Appropriate Interest Rate: • For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the specific borrowings. • For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifically to finance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Step 4 - Compute the Actual and Avoidable Interest. Actual Interest Weighted-average interest rate on general debt $100,000 $800,000 = 12.5% Avoidable Interest LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Step 5 – Capitalize the lesser of Avoidable interest or Actual interest. Journal entry to Capitalize Interest: Equipment 30,250 Interest expense 30,250 LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Comprehensive Illustration: On November 1, 2009, Shalla Company contracted Pfeifer Construction Co. to construct a building for $1,400,000 on land costing $100,000 (purchased from the contractor and included in the first payment). Shalla made the following payments to the construction company during 2010. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Pfeifer Construction completed the building, ready for occupancy, on December 31, 2010. Shalla had the following debt outstanding at December 31, 2010. Compute the weighted-average accumulated expenditures during 2010. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Compute the weighted-average accumulated expenditures during 2010. Illustration 10-4 Solution on notes page LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Compute the avoidable interest. Illustration 10-5 Solution on notes page LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Compute the actual interest cost, which represents the maximum amount of interest that it may capitalize during 2010, Illustration 10-6 The interest cost that Shalla capitalizes is the lesser of $120,228 (avoidable interest) and $239,500 (actual interest), or $120,228. LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E Shalla records the following journal entries during 2010: January 1 Land 100,000 Building (or CIP) 110,000 Cash 210,000 March 1 Building 300,000 Cash 300,000 May 1 Building 540,000 Cash 540,000 December 31 Building 450,000 Cash 450,000 Building (Capitalized Interest) 120,228 Interest Expense 119,272 Cash 239,500 LO 4 Describe the accounting problems associated with interest capitalization.

Acquisition of PP&E At December 31, 2010, Shalla discloses the amount of interest capitalized either as part of the nonoperating section of the income statement or in the notes accompanying the financial statements. Illustration 10-7 Illustration 10-8 LO 4 Describe the accounting problems associated with interest capitalization.

Valuation of PP&E • Companies should record property, plant, and equipment: • at the fair value of what they give up or • at the fair value of the asset received, • whichever is more clearly evident. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Cash Discounts — whether taken or not — generally considered a reduction in the cost of the asset. Deferred-Payment Contracts — Assets, purchased through long term credit, are recorded at the present value of the consideration exchanged. Lump-Sum Purchases — Allocate the total cost among the various assets on the basis of their fair market values. Issuance of Stock — The market value of the stock issued is a fair indication of the cost of the property acquired. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Exchanges of Nonmonetary Assets • Ordinarily accounted for on the basis of: • the fair value of the asset given up or • the fair value of the asset received, • whichever is clearly more evident. Companies should recognize immediately any gains or losses on the exchange when the transaction has commercial substance. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Accounting for Exchanges Illustration 10-10 * If cash is 25% or more of the fair value of the exchange, recognize entire gain because earnings process is complete. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Exchanges - Loss Situation Companies recognize a loss immediately whether the exchange has commercial substance or not. Rationale: Companies should not value assets at more than their cash equivalent price; if the loss were deferred, assets would be overstated. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Illustration: Information Processing, Inc. trades its used machine for a new model at Jerrod Business Solutions Inc. The exchange has commercial substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-in allowance of $9,000 for the used machine. Information Processing computes the cost of the new asset as follows. Illustration 10-11 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Illustration: Information Processing records this transaction as follows: Equipment 13,000 Accumulated Depreciation—Equipment 4,000 Loss on Disposal of Equipment 2,000 Equipment 12,000 Cash 7,000 Illustration 10-12 Loss on Disposal LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Exchanges - Gain Situation Has Commercial Substance. Company usually records the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and immediately recognizes a gain. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Illustration: Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate’s purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair market value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck. Interstate computes the cost of the semi-truck as follows. Illustration 10-13 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Illustration: Interstate records the exchange transaction as follows: Semi-truck 60,000 Accumulated Depreciation—Trucks 22,000 Trucks 64,000 Gain on disposal 7,000 Cash 11,000 Illustration 10-14 Gain on Disposal LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Exchanges - Gain Situation Lacks Commercial Substance—No Cash Received. Now assume that Interstate Transportation Company exchange lacks commercial substance. That is, the economic position of Interstate did not change significantly as a result of this exchange. In this case, Interstate defers the gain of $7,000 and reduces the basis of the semi-truck. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Illustration: Interstate records the exchange transaction as follows: Semi-truck 53,000 Accumulated Depreciation—Trucks 22,000 Trucks 64,000 Cash 11,000 Illustration 10-15 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Exchanges - Gain Situation Lacks Commercial Substance—Some Cash Received. When a company receives cash (sometimes referred to as “boot”) in an exchange that lacks commercial substance, it may immediately recognize a portion of the gain. The general formula for gain recognition when an exchange includes some cash is as follows: Illustration 10-16 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Illustration: Queenan Corporation traded in used machinery with a book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus cash of $10,000. Illustration 10-17 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E The portion of the gain a company recognizes is the ratio of monetary assets (cash in this case) to the total consideration received. Illustration 10-18 Solution on notes page LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E Queenan would record the following entry. Illustration 10-19 Cash 10,000 Machine 54,000 Accumulated Depreciation—Machine 50,000 Machine 110,000 Gain on disposal of machine 4,000 LO 5 Understand accounting issues related to acquiring and valuing plant assets.

Valuation of PP&E E10-19 variation:Carlos Arruza Company exchanged equipment used in its manufacturing operations plus $3,000 in cash for similar equipment used in the operations of Tony LoBianco Company. The following information pertains to the exchange. Instructions: Prepare the journal entries to record the exchange on the books of both companies. LO 5 Understand accounting issues related to acquiring and valuing plant assets.

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT